Buy-Sell Agreements: Does the Buyout’s Funding Mechanism Impact the Value?

In this fifth part in our series on buy-sell agreements, we address one of the more obscure questions relating to a valuation for buy-sell purposes (see the previous post in the series by clicking here).

Should the buyout’s funding mechanism be taken into consideration in the value?

Owner buyouts can be funded in a variety of ways, including the following:

Insurance policy proceeds (life or disability insurance)

Debt proceeds

Cash flow of the company

Although on the surface it may seem that the value of ownership interest and how a transaction involving that interest will be funded are two distinct issues, the funding mechanism can have a material impact on value depending on the language in the agreement. In other words, the value of a company and an ownership interest in the company can differ whether the value is measured before or after consideration of the funding.

A similar “before or after” valuation consideration exists with regard to the personal value and contribution of an owner to the business. An owner of the business is often also a key employee, whose skills and experience are a major contributor to the success of the business. Does the loss of that owner’s skills, experience, relationships, etc. cause the value of the business to decline the day after they exit? If so, should this be considered in the valuation?

Example: The First One Out Wins!

Let’s consider a common scenario for an ownership buyout. In this scenario, an owner/employee of the business will be retiring, and it is expected that the business will suffer some impact from the loss of the personal goodwill value of this owner/employee. Let’s further assume that the company plans to take on debt to buy out the owner/employee’s interest in the business.

The following “before and after” comparison shows the impact on the value of the company assuming a 5% decline in operating income (or “EBIT”) and debt service requirements. The decline in EBIT is the expected impact of the owner/employee leaving the business, and the debt service requirements relate to the buyout of their ownership interest:

As this example shows, the exit of a key owner/employee can severely impact the value of a business. The remaining owners may recoup some of the loss if they are able to execute the buyout using the “after” value. However, if the value is measured before these impacts, the ramifications to the remaining owners are much different. If a second owner wants or needs to exit the business soon after the first exit, the value of that owner’s interest may be drastically different than the value of the first owner’s interest. Owners may view this as simply a reflection of reality, or they may view it as creating an inherently unfair situation.

Planning Tip

The scenario illustrated above is a common one, and the impact on the equity value of the business is real. Two fundamental questions should be addressed by owners when contemplating exit transactions and documenting the process in a buy-sell agreement. First, how will a buyout be funded? There is no perfect answer for every situation, but considering all of the options and making an informed choice is important. Second, how will each existing owner’s interest be valued – inclusive or exclusive of considerations for issues such as personal goodwill and funding? It is important for the parties to discuss and agree on what is considered to be a fair outcome for all. Again, there is no perfect answer, just the answer that is agreed upon.

In our next post, we discuss options available in terms of the methods or approaches to estimating value.

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